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Eleven things I learned at the CorenetGlobal Summit in Phoenix September 23, 2010

Posted by Bob Cook in Alternative Workplace Strategies, Financial Planning & Analysis, Green Initiatives, Lease Accounting, Profession of Corporate Real Estate.

 1. 110 degrees doesn’t feel that bad in the shade.

2.  Face-to-face meetings are a nice complement to living “la vida webosphera”.

3.  Corenet Summits ain’t what they used to be, many long years ago… but…

4.  Even without Duck Soup, Summits are still pretty good.

5.  Topics presented in breakout sessions draw varying sizes of crowds.  My take:

6. “Alternative Workplace” is still in first place as a topic of interest to the most people.

7. “Career Planning” is close behind (perhaps because of all the members “in transition”)

8. “Green” is gaining ground fast and could overtake “Alternative Workplace” shortly, and …

9. “The New Lease Accounting”, while far behind (it wasn’t even given a prime time slot), is coming up fast (judging by the standing-room-only crowd at a 7:45 AM session on subject).

10. PHX is near the downtown convention center, allowing for a fast exit.

11.  Saguaro live to be 200 years old (according to art exhibit at PHX) and take ten years to grow one foot tall.

For-Profit Education and the Need for Leases on Balance Sheets September 12, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting.
Tags: , ,

September’s here, school is starting, out-of-work workers need retraining … and the for-profit education industry should be partying. Shareholders and managers of companies running places like University of Phoenix (APOL), Argosy University (EDMC) , Corinthian College (COCO), DeVry University (DV), Strayer University (STRA), and others should be having back-to-school beer busts. Events of this past summer, though, have dampened the industry’s prospects, and a sobering time is ahead.

Until recently, the industry had been on an expansion tear, as the unemployed and underemployed attempt to upgrade their credentials in a challenging job market. Fortune’s “100 Fastest-Growing Companies” lists DeVry (#46), Strayer Education (#74) and Corinthian Colleges (#79). This summer, though, the U.S. Department of Education announced that it wants to curtail access to federal funds for any for-profit education company where too many of its students don’t repay their college loans … particularly if the non-repayment is due to the fact that there’s no way their students can earn enough after graduation to make payments. As you might guess, the DOE action was prompted by its discovery that, in fact, this is the case for many companies in the sector. As a result, the future of these companies is suddenly in jeopardy. If their students can’t get government-supported student loans, enrollment will fall because many prospective students won’t be able to pay tuition. Fewer students will mean, of course, less revenue.

How will these companies fare? If you look at just their financial statements, you’d get the impression that the companies are so under-leveraged that they will easily be able to survive reduced revenue. The Apollo Group, owner of the ubiquitous University of Phoenix, with annual revenues of $4.8 billion and net income of $600 million, has only $350 million of long-term obligations. Another example: DeVry has annual revenue of $1.9 billion, net income of $280 million, and long-term obligations of only $106 million. A third example, particularly eye-catching: Strayer has annual revenue of $579 million, net income of $120 million and a measly $12 million of long-term obligations. All of these companies could pay off their long-term obligations, as shown on balance sheets, with only a portion of one year’s earnings.  Across the industry, financial statements make companies look strong.

Undoubtedly, some investors have bought the stock of for-profit companies thinking the companies offered a great combination of fast growth and strong financial structure … a combination that they could have known was too-good-to-be-true if only they had read the notes in the companies’ financial statements filed with SEC.

They would have, though, had to have read those notes very carefully … and thoughtfully … and knowledgeably … and not have overlooked the section on operating leases. The operating lease section is just one of many in the “Notes to Consolidated Financial Statements” included in 10-K submissions. These notes are generally intended to provide detailed information on the line items shown on the balance sheet and other financial statements. In the case of the operating lease section, however, information is about obligations that don’t appear as line items on the financial statements. Anyone without an accounting background could easily overlook the import of the section. And many probably have.

The truth is these for-profit education companies have hundreds of millions of dollars of operating lease obligations which are all “off-balance sheet” even though are as real as obligations like the bond debts which are “on-balance sheet”. In the case of Apollo, there are $757 million of future lease obligations … more than twice the amount of long-term obligations now shown on the balance sheet. At DeVry, future lease obligations total $579 million … more than five times the amount of long-term obligations shown. And at Strayer, future operating lease obligations total $218 million, which is … OMG! … more than 18 times (yes, that’s eighteen times, no decimal point is missing!) more than the amount of long-term obligations shown on the balance sheet.  (See Table A.)

Table A: Stats for Selected For-Profit Education Companies   (in $ millions unless otherwise noted, rounded to simplify presentation)

Annual Revenue (1) 4,800 2,000 1,800 1,900 2,500 1,500 580
Annual Net Income (1) 600 210 150 280 170 350 120
Long-Term Liabilities (2) 350 200 400 100 1,930 175 12
Future Operating Lease Obligations (2) 760 725 635 580 1,140 185 220
Lease Obligations As % of Long-Term Liabilities 217% 362% 159% 580% 59% 106% 1833%

Note 1:  Last twelve reported months.   Note 2: Last annual 10-k report.

If these operating lease obligations were included on balance sheets, investors would get a much better idea of the financial structure of the companies. They would understand how these companies have funded their operations with operating leases, which is not necessarily bad, but it does mean that these companies are not as financially secure as financial statements would lead one to believe.  These leases represent high fixed expenses that put these companies at solvency risk should their revenue decline. If all leases were on the balance sheet, investors would understand that these companies are, in fact, highly-leveraged … via operating leases.

And while it is true that, in the case of a bankruptcy filing, a company may have the right to cancel leases such that, theoretically, operating leases are less set in concrete than are obligations like bonds, from a practical point-of-view, how can a company actually cancel leases and improve its situation?  Any wholesale canceling of leases would be tantamount to going out of business.  So while leases might, legally-speaking, be canceled, this is a mute point, practically-speaking.

And so we have a situation where the largest obligations of these for-profit education companies do not appear on their balance sheets even though balance sheets are supposed to provide a snapshot of a company’s financial situation, showing what it owns and what it owes. Balance sheets aren’t doing what they’re supposed to do. And while savvy stock analysts understand that lease obligations are not on the balance sheet but can be seen in the notes to the financial statements, even some of them probably don’t fully account for these obligations when evaluating companies.  And they probably don’t go out of their way to bring these obligations to the attention of investors when things are booming and they have a “buy” recommendation out.  For many reasons, obligations noted in footnotes just don’t carry the same weight as those seen on balance sheets. Out-of-site, out-of-mind.

So what should be done?

Well, what should be done is being done… albeit, belatedly. The FASB and the IASB are working together to create a new accounting standard for leases. The proposed standard is outlined in the Exposure Draft on Leases issued by the two accounting bodies in mid-August. The thrust of the new standard is that leases will go onto the balance sheet … as both a right-to-use asset and a lease liability … in an amount equal to the present value of likely lease payments. This proposal is open for comments until December 15, 2010, and the accounting boards plan on issuing the new standard by June 2011.

Many people aren’t enamored with the proposed new accounting. It is going to cause a lot of pain to companies in terms of the effort required to comply and has many implications that reach far beyond accounting, per se.  

The case of the for-profit education industry, though, shows how important lease-accounting change is if financial statements are to serve their function. This will become all the more clear if revenues of these for-profit companies decline, and one or more of them file for bankruptcy protection.  If this happens, the for-profit education sector will serve as “Exhibit A” in the argument for why leases should go on balance sheets.

Click here to read more posts about the new lease accounting.

For your self-preservation, Mr Corporate Real Estate Exec … September 2, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
Tags: , ,

Regarding the new lease accounting, Mr. Corporate Real Estate Exec, you really shouldn’t be waiting to get direction from your accounting folks. You need to understand the implications of this new standard now and begin making preparations to comply. 

The Exposure Draft on Leases was issued by IASB and FASB in mid-August. Your company’s technical accounting folks are probably reviewing it, digesting it, and starting to think about its implications for the company financial statements and for its accounting processes. Their world is different from yours, though … and you can’t expect them to anticipate and address the challenges you will be facing as a result of the accounting change. You need to address this thing yourself; get ahead of it … before it gets ahead of you. 

Your accounting folks will be quantifying the impact of the accounting on company financial statements. They’ll not, though, be worrying about how it’s going to affect your real estate budgets and how you’ll have to change formulas for allocating expenses to business units. Your accounting folks will be preparing process diagrams showing how the accounting processes will flow once they get the required lease information from you. They’ll not, though, be worrying about how you meet the challenge of assembling, recording and providing all that information in a SOX-compliant manner. Your accounting folks will see and maybe advise you on how the structure of real estate transactions affect the financial statements. They’ll not, though, be the ones who will have to justify the structuring decisions you are making today … decisions that will suddenly affect company financial statements when the accounting is adopted because there will be no grandfathering of existing leases. 

The heavy-lifting in terms of compliance (not to mention, the managing of implications for real estate strategy) is going to be done by corporate real estate departments, not accounting departments. You’ll have to design new SOX-compliant processes to record lease information (much of which is not now in lease administration systems) and to make assumptions about future needs. You’ll have to implement new IT systems or at least enhance your existing systems. You’ll have to revamp your charge-back systems and communicate that change to your internal clients. You’ll have to audit your present lease information for completeness and accuracy. You’ll have to hire and train people, or engage service-providers, to manage the new processes, input data, and collaborate with the accounting department.  

Yes, this accounting change is going to pose major challenges for you, Mr. Corporate Real Estate Exec. It may be soothing to think that you can wait to hear from your accounting folks on this issue before taking action, but you do so at your own peril. The challenges are many and the time available to comply, while not yet prescribed by the accounting boards, is likely to be much less than what you’ll think you need. The sooner you start, the more time you’ll have.  

Don’t be one of the corporate real estate execs … and there will be some … who don’t address this until their accounting department gives them direction. Here is what will unfortunately happen in many situations: The accounting department will eventually issue a list of lease data that the corporate real estate exec will have to provide. Not knowing, though, how difficult it is to assemble and record this information, the accounting department will not issue the list until there is insufficient time and industry resources to put the data-assembly-and-recording processes and systems in place before the standard must be adopted.

That situation … a career-killer, if ever there was one … is not one you want to find yourself in.


Click here for more posts on the new lease accounting.